Diversification is the silver bullet

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So, they say there are no silver bullets, but for dealing with uncertainty, diversification is as close as you can get. Instead of betting that the future will turn out one way, spread your bets across a diverse portfolio of likely possibilities.

I haven’t buried the lede, so there is going to be no surprise twist here, but I wanted to tease this out to show how widely applicable this concept is.

Company boards are made up of directors that need to make decisions about the future of the company. No-one knows the future for certain, so the background and experience of the decision-makers is critical for how good their decisions are. Instead of having every decision-maker with the same background and experience, having a spread of backgrounds and experiences improves the quality of the board. There are several pieces of research showing this, but one example reported in Forbes shows that, compared with individuals, a gender-diverse team makes better decisions 73% of the time, and teams that also have age and geographic diversity are better 87% of the time.

There is a danger that this seems completely obvious. Let’s just pause for a little and consider that it’s actually a little counter-intuitive. There is a proverb that has been around since the 16th century that too many cooks spoil the broth. Certainly, for a complicated task, an individual with deep expertise can often accomplish it better than a team. In fact, to underline that point, the same study reported in Forbes from before noted that diverse teams are more likely to struggle to put their decisions into action.

The difference is between complicated and uncertain. A complicated task can be made easier through the application of appropriate tools, skills and experience. Applying these things to an uncertain task doesn’t make it less uncertain. Producing a 7 day weather forecast is complicated. Getting it completely correct is uncertain.

This same logic applies in the world of venture capital. A VC firm will raise a fund to invest in a portfolio of startups, rather than just one. However, the same VC firm will typically seek out startups that each aim to win in a single market or technology area. Knowing which startup will become a unicorn is uncertain, so is best approached in a portfolio fashion. A VC fund of $50M could include something like a dozen startups, and there’s a well-known rule of thumb that only a third of startup investments will return more than their initial investment. (On the other hand, executing a startup is a complicated endeavour, and it benefits from simplifying and focussing where possible.)

Sometimes a VC firm develops an investment thesis for their fund, such as where they believe a particular technology or market should be the focus for their investments. Here’s a collection of over a dozen different VC investment theses, but a stark example is when Kleiner Perkins announced in 2008 that they would form a fund to invest in iPhone (and later iPad) app companies due to their belief in the potential of Apple’s iPhone. However, such VC firms still consider the winners in that space to be uncertain, and hence diversify their investments across multiple possible winners, e.g. Kleiner Perkins ended up investing in 25 companies. Similarly, investors in such a focussed fund (known as limited partners) are likely to diversify their investments across multiple VC funds, in order to mitigate the uncertainty that a particular investment thesis is wrong. An example here is Yale’s endowment fund, which historically invested in funds across VCs such as Andreessen Horowitz, Benchmark and Greylock Partners.

When it comes to corporate innovation, the lessons are the same. A particular corporate should take a portfolio approach to emerging opportunities. There might be some hypotheses that a corporation has developed about the opportunity sizes in particular markets, products or technologies. However, no one knows for sure how the future will turn out, so spreading risk across multiple opportunities is prudent.

The recent book from Geoffrey Moore called Zone to Win argues that a company can incubate only one major new business at a time, or risk spreading executive attention and corporate resources too thin. While there are examples of large companies like Amazon, Baidu, Apple, Google and Microsoft who are able to incubate multiple such initiatives at once, there are few companies at this scale.

However, when the expenditure and resources required to progress a new initiative are relatively small, and the likelihood of success of such an initiative is still very uncertain, it makes a lot of sense to spread the company’s investment across a number of these initiatives. Diversification may involve a range of possible time horizons, market segments, product areas, or technology domains. Spread the risk to increase the chance of overall success.

Whether it is the uncertainty relating to having relevant experience for board-level decisions, knowing which startups will hit home runs, or picking the right opportunities to explore within a corporate innovation function, the silver bullet is the same. Diversify across a variety of good options.

I have qualifications in computer science, philosophy and finance, and spent two decades working in early stage product/tech in the telecommunications sector